Thursday, March 29, 2012

Thoughts (Rant) on the Financial Services Industry

It's time for my once-every-couple-years financial rant.  For those looking for Baugh family updates, please disregard this message.  For those interested in saving hundreds of thousands of dollars of unecessary financial management expenses (and hence 5-10 years of your life sitting in a cubicle) over the next 5 decades of your lives, read on.

I have good friend looking for work.  When he told me that he had a possible opportunity working for Fidelity as an investment adviser, I said "it'll be a pay check, but I predict you'll grow tired over time of giving shoddy advice to clients."  When my friend asked why he couldn't give good financial advice to clients, I responded "because the entire industry is based on swindling customers."  After a few minutes of discussion and disbelief on his part, I proposed calling Fidelity to see what financial advice they would give me if I played dumb.

Here's the scenario that I conveyed to the Fidelity representative:  I received an inheritance of 100k and it was currently sitting in a taxable savings account.  I wanted it to keep up with inflation at a minimum, but I also wanted it to grow.  I could tolerate risk if it provided long term growth.  I wanted a "hands off" approach to investing.

My friend, who was on mute during this conference call, said that the "hands off" approach to investing was too much of a trap.  I disagree, because 95% of the public would give this same response.

In any regard, this is the advice that the financial advisor gave me.  Have Fidelity actively manage my portfolio for a base fee of 1% per year.  Since they invest in actively managed mutual funds, there would be an additional 1% of mutual fund expenses passed on to me.  In total, I would expect about 2% in fees per year.

I predict that the stock market will return about 6-7%/year over my lifetime, with inflation running about 2-3%.  The difference, or 4ish%,  is what I predict the "real return" on the stock market to be.

Countless academic studies have shown that mutual funds, in aggregate, produce gross (before fee) returns what the market does.  This makes sense.  These same studies show that mutual funds produce inferior returns after accounting for management expenses.  The best and brightest finance professors that I have come in contact with advocate index funds as a low-cost way of guaranteeing yourself a market return.

So this financial advisor was essentially advising me to forfeit half (2%) of my real return (4%) for the rest of my life in fees.  His answer included references to how all of the "rebalancing" would be taken care of for me.  This was his attempt to maintain the facade of the industry.  I explain what "rebalancing" really is down in the bullets below.

I find this to be an entirely unacceptable business model.  Financial advisers should, and are obligated by law, to act as fiduciaries, which is a fancy word for someone who acts n your best financial interest.  Inherent in their compensation structure is a direct conflict to your financial success:  a 1% drag on your returns for financial managment fees and an additional 1% drag on your returns if they invest your funds in mutual funds for the rest of your life..  I ended the conversation with a confirmed disgust for the industry.

The stock market seems like a scary place to be.  The financial services continued livelihood depends on the perpetuation of the myth that no lay person would understand how to possibly navigate the complexities of the market.  That is a bunch of BS.

In the following bullets, I'll give you all of the financial advice that you'll need to know for life.  And I'm giving it to you for free, because I like you.  Please share it with your friends:

  • My generation is of the first to deal with the diminishing prevalence of pensions.  As a result, the onus is on us to figure out the financial maze that is in front of us.  We need to figure out how much we need to save and where to invest it.
  • As a general rule of thumb, you can retire when you have stockpiled enough investments such that your expenses are less than 4% of your stockpile.   A less clumsy way of saying this is that you can retire when you have accumulated 25 times your annual expenses in investments.  Thus, if it takes you 30k/year to live on, you can retire when you accumulate 750k (30k/.04 or 30k*25) in investments.  Of course, taxes factor into this as well, so this would only increase that number.
  • The most important skill to develop in reaching financial independence is to learn to live happily on less than you make.  This produces "savings."  Intelligent consumption will get you there, as will the ability to be easily satiated.  Those two attributes working in harmony will create a savings symphony.
  • These savings should generate returns for you....hopefully real returns which exceed the rate of inflation.
  • Financial markets have historically provided good returns, and should continue to do so in the future.
  • The best way of maximizing your after-fee returns, and thus your savings, is to invest passively in index funds, which are like mutual funds except for they don't try to beat the market, nor do they charge some hot shot manager a huge salary for failing to do so on an after-fee basis.
  • The simplest way to decide your mix of bonds/stocks and domestic/international is to invest in a lifecycle fund, which automatically decides this for you and changes allocations over time.  For example, the Vanguard Target Retirement 2050 fund (or its equivalent if you plan to retire in another year) is the only fund that you'd need to own for your entire life.  It invests in many thousands of companies, so you need not worry about lack of diversification because you are invested in a single fund.  It will invest in both bonds (loans) and stocks (ownership).
  • Another way to maximize your returns is to legally minimize the amount of taxes owed on returns.  This is accomplished through tax-favored accounts, such as 401k's, IRAs, and 529s for college.
  • If a lifecycle fund isn't available to you at a reasonable cost (i.e. <0.25%/year), then reconstruct your own portfolio with low-cost index funds and rebalance annually.  Rebalancing is a fancy word for making sure your allocation remains what you want it to over time.  A good baseline is to look at the composition of the  Vanguard Target Retirement 2050 (or equivalent) fund as shown here (Note that this Target Retirement fund consists of only 3 funds:  total bond, total domestic stock, total international stock....this isn't rocket science and buying 3 funds is something that anyone can do, which is what the financial services industry doesn't want you to know).  Rebalancing takes about 2 minutes per year and can be accomplished with a few mouse clicks at home.
  • Exploit 401k matching.
  • Exploit Roth IRA contributions every year.  Currently the limit is 10k/year per couple.
  • If you distrust the above advice or want a second opinion, seek out a "fee only" financial planner.  They receive an hourly rate for giving advice to you.  This is a great, honest, and sustainable business model. Hopefully you find a good one.
Of course retirement and financial independence should not be our only goal in life.  Enjoying each and every day is the whole point rather than longing for a distant, perfect, tomorrow.  Enjoying your employment will have profound effects on your happiness given the amount of time spent there.  I would argue quality time away from work has profound effects on happiness as well....which is precisely my objective.  I want to maximize the amount of quality time that I have away from work and eventually get to the point where I can go to work when/where I want because I have that financial freedom.  Learning to be happy living on next-to-nothing (well below the poverty line) is the most important skill that we've developed that has allowed us to put the corporate rat race on hold for a few years to expand our education and converge closer to our goals.  It's a pretty empowering feeling.

For those I haven't formally introduced the blog to:  I highly recommend reading: to get a hilarious and well articulated glimpse into the mind of someone that I have a in lot common with.

* Update * The advice that I received was actually worse than I thought.  For one, they didn't tell me that I should use this money to fund an IRA.  Additionally, fully knowing that I would be in a taxable account, they mentioned that each time they transact I will be hit with a taxable event.  These two factors combined amount to a huge oversight on their part, which conveniently aligns with their financial interests.

** Update2 ** Dilbert author hits the nail on the head with his commentaries: